Musings on economics and politics, with a special interest in free banking and monetary disequilibrium.

Saturday, January 11, 2014

Testing Market Monetarism

Krugman claimed that 2013 would be a test of Market Monetarism. Market Monetarists rejected that claim, because the Fed didn't target the level of nominal GDP. The Fed didn't give up on interest rate targeting. The Fed continued to pay interest on reserves. It is also true that the Fed didn't start trading index futures contracts on nominal GDP. (Even I count that last one as asking a lot.)

Kling has accused Sumner of making Market Monetarism irrefutable. Kling said that suppose the Fed said that it was targeting the level of nominal GDP, but the business cycle continued as before. Market Monetarists would either accept that targeting the level of nominal GDP did no good, or they would say that the Fed was not really targeting the level of nominal GDP. He said that he anticipated that we would do the second thing.

I think this is due to Sumner's claim that nominal GDP expectations are the stance of monetary policy. Sumner argues that actual nominal GDP varies little from expected future nominal GDP, and so that when nominal GDP changes, especially if the change is significant, it was due to changes in expected future nominal GDP. And that means it changed due to a change in the Fed's monetary policy stance.

How could this be refuted? I think Kling has in mind a situation where actual nominal GDP deviates from the target, and fluctuates as before. If shifts in nominal GDP are defined to be loose or tight monetary policy, then nominal GDP level targeting hasn't failed. The Fed has failed to implement the proper monetary policy by definition.

But that isn't all there is to Market Monetarism.

In my view, the most obvious test would be a situation where nominal GDP does remain close to the target growth path, but the business cycle, understood to be fluctuations in real output and employment, continues as before. Obviously, inflation would be strongly countercyclical.

Now, Market Monetarists believe that booms and busts would continue to exist even with perfectly successful nominal GDP level targeting due to supply-side factors. So, the test would be whether there really are any "demand-side" business cycles. Or, whether an alternative regime, like inflation targeting exacerbates supply-side recessions. I think the test would need to compare the fluctuations of real output and employment under a period of nominal GDP level targeting to some other monetary regime.

Of course, it might be possible to actually identify supply side factors directly. Are the business cycles under nominal GDP level targeting more closely related to various supply side factors?

Now it would be really interesting to see how nominal GDP level targeting performs with a financial crisis. If nominal GDP remained on target, but real output fell and inflation rose, presumably because of the inability of the financial sector to efficiently allocate credit, then that would count against nominal GDP level targeting.

But Kling isn't worried about that sort of test. It is rather the central bank adopts nominal GDP level target but fails to hit the target.

One possibility is that nominal GDP fluctuates exactly as before, but around the target. That would be the most challenging scenario. How hard are they trying keep nominal GDP on target? Of course, if they say, we can't do it because short term interest rates would change too much, or the quantity of base money would change too much, then we would say they aren't really trying. They are targeting the level of nominal GDP subject to the constraint that something else, such as money market interest rates, remain within reasonable bounds.

On the other hand, if nominal GDP was below target despite interest rates on reserves being negative, a significant currency drain, and the Fed owning every asset it can legally own, then that would count against Market Monetarism. Sure, we could say that they could still do more, but Market Monetarists generally argue that with a nominal GDP level target, they should be able to raise nominal GDP.

On the other side, if nominal GDP was above target even after the central bank has sold off all of its assets, then maybe they are doing the best they can.

Of course, if nominal GDP is fluctuating around the target, it is possible that the changes in base money are excessive and causing overshooting.

But what about a different scenario. Suppose nominal GDP shifts to a new trend, and the Fed is committed to return to the target growth path, but nothing it does shifts nominal GDP. If the problem is not excessive fluctuations around the target, but rather stabilizing below target, then the test of whether they have bought all the assets they can or sold off all of their assets would be telling.

If they were really trying and nominal GDP would not move to target, that would count against Market Monetarism.

Interestingly, Market Monetarists argue that a nominal GDP level target would generally require more modest changes in base money or interest rates than inflation targeting. This is because of automatic stabilizing features of the regime. This could be tested by looking at the variation of base money or interest rates controlled for deviations of the goal for target.

Finally, there is the test of whether the market expectation of future nominal GDP strongly impacts current nominal GDP. If the expectation of future nominal GDP can be measured, and it stays on target, but nominal GDP fluctuates as before, then this would be a test of that view.

However, the better test would be if nominal GDP were expected to deviate from target, and it really stayed the same.

Suppose nominal GDP level targeting is implemented, and the market shorts nominal GDP contracts. The Fed takes the opposite long position. Nominal GDP remains on target. This would count against Sumner (and my) view that index futures convertibility is desirable.